RISK AND RETURN

Return expresses the amount which an investor actually earned on an investment during a certain
period. Return includes the interest, dividend and capital gains; while risk represents the
uncertainty associated with a particular task. In financial terms, risk is the chance or probability
that a certain investment may or may not deliver the actual/expected returns.
The risk and return trade off say that the potential return rises with an increase in risk. It is
important for an investor to decide on a balance between the desire for the lowest possible risk
and highest possible return.

Risk Analysis
Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk in
investment is defined as the variability that is likely to occur in future cash flows from an
investment. The greater variability of these cash flows indicates greater risk.
Variance or standard deviation measures the deviation about expected cash flows of each of
the possible cash flows and is known as the absolute measure of risk; while co-efficient of
variation is a relative measure of risk.
For carrying out risk analysis, following methods are used-
i. Payback [How long will it take to recover the investment]
ii. Certainty equivalent [The amount that will certainly come to you]
iii. Risk adjusted discount rate [Present value i.e., PV of future inflows with discount
rate]
However, in practice, sensitivity analysis and conservative forecast techniques being simpler and
easier to handle, are used for risk analysis. Sensitivity analysis [a variation of break-even
analysis] allows estimating the impact of change in the behavior of critical variables on the
investment cash flows.

Types of risks
There a number of differing types of risk that can affect your investments. While some of these
risks can be reduced through a number of avenues – some of them simply have to be accepted
and planned for in any investment decision.

a. Macro Level Risks

On a macro (large-scale) level there are two main types of risk, these are:
i. systematic risk and
ii. unsystematic risk.

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Systematic Risk - is the risk that cannot be reduced or predicted in any manner and it is almost
impossible to predict or protect yourself against this type of risk. Examples of this type of risk
include interest rate increases or government legislation changes. The smartest way to account
for this risk, is to simply acknowledge that this type of risk will occur and plan for your
investment to be affected by it.
Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of
risk affects a very small number of assets. An example is news that affects a specific stock such
as a sudden strike by employees. Diversification is the only way to protect yourself from
unsystematic risk.

b. Micro Level Risks

While the above risk types are the macro scale levels of risk, there are also some more important
micro (small-scale) types of risks that are important when talking about the valuation of a stock
or bond. These include:
i. Business Risk
The uncertainty of income caused by the nature of a company’s business measured by a ratio of
operating earnings (income flows of the firm). This means that the less certain you are about the
income flows of a firm, the less certain the income will flow back to you as an investor. The
sources of business risk mainly arises from a companies’ products/services, ownership support,
industry environment, market position, management quality etc.
ii. Liquidity Risk
The uncertainty introduced by the secondary market for a company to meet its future short-term
financial obligations. When an investor purchases a security, they expect that at some future
period they will be able to sell this security at a profit and redeem this value as cash for
consumption – this is the liquidity of an investment, its ability to be redeemable for cash at a
future date. Generally, as we move up the asset allocation table – the liquidity risk of an
investment increases.
iii. Financial Risk
Financial risk is the risk borne by equity holders due to a firm’s use of debt. If the company
raises capital by borrowing money, it must pay back this money at some future date plus the
financing charges (interest charged for borrowing the money). This increases the degree of
uncertainty about the company because it must have enough income to pay back this amount at
some time in the future.
iv. Exchange Rate Risk
The uncertainty of returns for investors that acquire foreign investments and wish to convert
them back to their home currency. This is particularly important for investors that have a large
amount of over-seas investment and wish to sell and convert their profit to their home currency.

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If exchange rate risk is high – even though a substantial profit may have been made overseas, the
value of the home currency may be less than the overseas currency and may erode a significant
amount of the investments earnings. That is, the more volatile an exchange rate between the
home and investment currency, the greater the risk of differing currency value eroding the
investments value.
v. Country/political Risk
This is also termed political risk, because it is the risk of investing funds in another country
whereby a major change in the political or economic environment could occur. This could
devalue your investment and reduce its overall return. This type of risk is usually restricted to
emerging or developing countries that do not have stable economic or political arenas.
vi. Market Risk
The price fluctuations or volatility increases and decreases in the day-to-day market. This type of
risk mainly applies to both stocks and options and tends to perform well in a bull (increasing)
market and poorly in a bear (decreasing) market. Generally with stock market risks, the more
volatility within the market, the more probability there is that your investment will increase or
decrease.
vii. Interest Rate Risk
Interest rate risk is the risk that an investment's value will change as a result of a change in
interest rates. This risk affects the value of bonds more directly than stocks.
viii. Credit or Default Risk
Credit risk is the risk that a company or individual will be unable to pay the contractual interest
or principal on its debt obligations. This type of risk is of particular concern to investors who
hold bonds in their portfolios. Government bonds have the least amount of default risk and the
lowest returns, while corporate bonds tend to have the highest amount of default risk but also
higher interest rates. Bonds with a lower chance of default are considered to be investment grade,
while bonds with higher chances are considered to be junk bonds.
ix. Return Analysis
An investment is the current commitment of funds done in the expectation of earning greater
amount in future. Returns are subject to uncertainty or variance Longer the period of investment,
greater will be the returns sought. An investor will also like to ensure that the returns are greater
than the rate of inflation.
An investor will look forward to getting compensated by way of an expected return based on 3
factors -
1. Risk involved
2. Duration of investment [Time value of money]
3. Expected price levels [Inflation]

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The basic rate or time value of money is the real risk-free rate [RRFR] which is free of any risk
premium and inflation. This rate generally remains stable; but in the long run there could be
gradual changes in the RRFR depending upon factors such as consumption trends, economic
growth and openness of the economy.
If we include the component of inflation into the RRFR without the risk premium, such a return
will be known as nominal risk-free rate [NRFR]
NRFR = (1 + RRFR) * (1 + expected rate of inflation) - 1
Third component is the risk premium that represents all kinds of uncertainties and is calculated
as follows -
Expected return = NRFR + Risk premium

Risk and return trade off

Investors make investment with the objective of earning some tangible benefit. This benefit in
financial terminology is termed as return and is a reward for taking a specified amount of risk.
Risk is defined as the possibility of the actual return being different from the expected return on
an investment over the period of investment. Low risk leads to low returns. For instance, in case
of government securities, while the rate of return is low, the risk of defaulting is also low. High
risks lead to higher potential returns, but may also lead to higher losses. Long-term returns on
stocks are much higher than the returns on Government securities, but the risk of losing money is
also higher.
Rate of return on an investment cal be calculated using the following formula-
Return = (Amount received - Amount invested) / Amount invested
The risk and return trade off says that the potential rises with an increase in risk. An investor
must decide a balance between the desire for the lowest possible risk and highest possible return.

Low risk
Return Low return

High risk
High return

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Risk (standard deviation)

Risk return tradeoff

The trade-off between required return and risk that is used to determine risk-adjusted discount
rates is derived from the presumption that investors prefer higher expected returns, but seek to
avoid higher levels of risk. Based on this presumption, all investors will choose to invest in
portfolios of securities that are efficient in the sense that their portfolios either

Attain the maximum possible level of expected return for a given level of exposure to risk

Attain the minimum level of risk for a given target level of expected return.

Portfolios which satisfy either of the above criteria are referred to as efficient portfolios.
Assuming that all investors choose efficient portfolios, we will show that the required rate of
return for individual securities depends on how much risk that security contributes to the risk of a
“well-diversified” portfolio.

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MEASURES OF RETURN
An investor evaluates alternative investments by estimating and evaluating the expected risk-
return trade off of the investment. Three types of returns can be calculated, namely;
1. Historical rate of return
2. Expected rate of return
3. Required rate of return

1. Historical rate of return

When evaluating alternative investments for inclusion into a portfolio, you often compare
investments with widely different prices and lives. To properly evaluate such investments you
must accurately compare their historical rates of return.

Realized rates of return are called ex-post rates of return. In contrast, ex-ante rates of return are
rates of return that are expected to occur in the future. Investors may use historical rates of return
to estimate future returns and risk of various securities - estimates that are needed to make
portfolio investment decisions.

Two types of returns can be calculated, namely;

i. Holding period return (HPR)
ii. Holding period yield (HPY)

2. Holding period return (HPR)

When evaluating an investment, we first calculate its historic rate of return over the holding
period i.e. the period during which you own the investment. It’s calculated as below;

HPR = Ending value of investment (including cash flows)

Beginning value of investment

HPR is always equal or greater than zero but can never be a negative value. A value greater than
one indicates a positive rate of return and vice versa.

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Holding period yield (HPY)

Investors generally evaluate returns in percentage terms and on an annual basis. Therefore, it’s
important to convert the HPR into a percentage. This is done by subtracting one from HPR as
below;

HPY = HPR - 1

Annual HPR and HPY

Annual HPR
The annual HPR is calculated as follows;

Annual HPR = HPR1/n

n – Number of years an investment is held

Annual HPY
The annual HPY is calculated as follows;

Annual HPY = annual HPR - 1

Example one
An investment costs sh 250,000 and its worth sh 350,000 after being held for two years.
Calculate;
i. HPR
ii. HPY
iii. Annual HPR
iv. Annual HPY

Example two

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An investment worth sh 100,000 is held for six months and earns a return of sh 12,000.
Calculate;
i. HPR
ii. HPY
iii. Annual HPR
iv. Annual HPY

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Computing mean historic return

Over a number of years, an investment will give varying rates of returns therefore a mean annual
rate of return should be calculated. Such an average can be calculated either for a single or a
portfolio of investments.

Single investments mean historic return

Given a set of rates of returns (HPYs) for an individual investment two measures of performance
can be used, namely;

1. The Arithmetic Mean (AM) - a measure of mean return equal to the sum of annual returns
divided by the number of years. It is given by:

Arithmetic mean (AM) = ∑HPY

n
2. The Geometric Return (GM) - is an averaging method that compounds rates of return. That is,
if sh 1 is invested in Period 1, then it will be worth sh (1+R1) at the end of Period 1. The
geometric method assumes that sh (1+R1) is invested in Period 2. At the end of Period 2, the
investment will be worth the amount invested at the beginning of Period 2 times the value of a
dollar invested in Period 2. That is, the investment at the end of Period 2 is worth sh (1 + R1)(1 +
R2).

Continuing this procedure over n periods, we get the value at the end of n periods. Therefore, the
average (or mean) geometric rate of return is the nth root of the product of the annual holding
period returns for n periods, minus one (1). It is calculated as:

Geometric mean (GM) = (∏HPR)1/n - 1

∏ - the product of annual HPRs i.e. HPR1 x HPR2 x…. HPRn

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Example one
The data below relates to an investment;

Year Beginning value Ending value

1 100,000 115,000
2 115,000 138,000
3 138,000 110,400

Required
Calculate
i. Arithmetic mean (AM)
ii. Geometric mean(GM)

Example two
An investment has the following historic rates of returns
Year Beginning value Ending value
1 110,000 110,000
2 110,000 137,500
3 137,500 123,800

Required
Calculate
i. Arithmetic mean (AM)
ii. Geometric mean (GM)

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Portfolio investments mean historic return

The mean HPR of a portfolio of investments is measured as the weighted average of the HPYs of
the individual investments in the portfolio or the overall change in the value of the portfolio. The
weights used in computing the averages are the relative beginning market values for each
investment.

Example one
A portfolio of investments consists of the following individual investments and their market
values;

Investment Number of Beginning Beginning Ending Ending

shares price market price market value
values
A 100,000 10 1,000,000 12 1,200,000
B 200,000 20 4,000,000 21 4,200,000
C 500,000 30 15,000,000 33 16,500,000
Total 20,000,000 21,900,000

Required
Calculate the weighted HPY of the portfolio of investment

Example two
Investment Beginning Ending values
values
A 2,000,000 2,100,000
B 5,000,000 5,400,000
C 3,000,000 3,300,000
Total 10,000,000 10,800,000

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Required
Calculate the weighted HPY of the portfolio of investment

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2. Expected rate of return

The expected return from investing in a security over some future holding period is an estimate
of the future outcome of this security.
Although the Expected Return is an estimate of an investor’s expectations of the future, it can be
estimated using either ex ante (forward looking) or ex post (historical) data.
If the expected return is equal to or greater than the required return, purchase the security.
Regardless of how the individual returns are calculated, the Expected Return of a Portfolio is the
weighted sum of the individual returns from the securities making up the portfolio:

Expected return E(R) = ∑Probability of returns x possible return

= ∑P1R1 + P2R2 + …. PnRn

Example one
An investor is planning to invest in the following conditions;
Economic conditions Probability Rate of return
Strong economy; no inflation 0.15 0.4
Weak economy; above average inflation 0.15 - 0.2
No major change in the economy 0.7 0.1

Required
Calculate the expected rate of return

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Example two
An investor has 10 possible outcomes ranging from - 40% to 50% with the same probability of
0.1. Calculate the expected return.

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Required Rate of Return (RRR)

The required rate of return is the minimum return that a company or an investor expects to
achieve if it invests in a project or business. The required rate of return is influenced by:
Risk of the investment. A company or investor may insist on a higher required rate of return for
what is perceived to be a risky investment, or a lower return on a correspondingly lower-risk
investment.
Liquidity of the investment. If an investment cannot return funds for a number of years, this
effectively increases the risk of the investment, which in turn increases the required rate of
return.
Inflation. The required rate of return must be layered on top of the expected inflation rate. Thus,
a high expected inflation rate will drastically increase the required rate of return.
The required rate of return is useful as a benchmark, below which possible projects and
investments are discarded. Thus, it can be an excellent tool for sorting through a variety of
investment options.
The required rate of return is not the same as the cost of capital of a business. The cost of capital
is the cost that a business incurs in exchange for the use of the debt, preferred stock, and
common stock given to it by lenders and investors. The cost of capital represents the lowest rate
of return at which a business should invest funds, since any return below that level would
represent a negative return on its debt and equity. The required rate of return should never be
lower than the cost of capital, and it could be substantially higher.
The level of the required rate of return, if too high, effectively drives investment behavior into
riskier investments. Thus, a 3% rate of return would allow one to invest in a variety of low-risk
opportunities, whereas a 15% rate of return would likely eliminate the lower-risk options,
leaving an investor with a much smaller number of higher-risk alternative investment
opportunities

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MEASURES OF RISK
Risk is the uncertainty that an investment will earn its expected rate of return. The various
measures of risk include;
Variance
Standard deviation
Coefficient of variation

Variance
Variance is the average of the squares of the distance between each value from the mean. The
larger the variance, the greater the risk. Variance is calculated as follows;

Variance = ∑ probability x (possible returns – expected returns)2

= ∑P R – E(R) 2

Standard deviation
The standard deviation is the square root of variance. It shows variability of measurements from
the mean. It’s calculated as follows;

2
= √∑P R – E(R)

Coefficient of variation (COV)

This is a measure of relative variability which indicates risk per unit of expected return. It’s
determined as follows;
COV = Standard deviation of returns
Expected rates of return

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Example one
An investor is considering investing in the stock market. One of the stocks he has identified has
the following characteristics;

Probability Possible rate of return

0.15 0.3
0.15 - 0.2
0.7 0.5

Required
Compute;
i. Expected rate of return for the investment
ii. The variance of the return
iii. The standard deviation of the return
iv. COV
Example two
The information below represents the HPYs for common stocks in the Nairobi stock exchange;
Year Annual rates of return
Year Annual rates of return
2011 0.07
2012 0.11
2013 - 0.04
2014 0.12
2015 - 0.06
Required
Calculate;
i. Arithmetic mean annual rate of return
ii. Variance
iii. Standard deviation
iv. COV

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